The two guys that work with me in Colorado – Chris Wand and Seth Levine – are visiting me in Alaska this week. We started joking about all the ridiculous things we (VCs) say on a regular basis. At the risk of exposing “super secret VC information”, I thought I’d write up a few of these phrases along with what they actually mean.
Oh – and on the topic of “giving away state secrets”, Matt Blumberg has a great post up on How to Negotiate a Term Sheet with a VC. This is a must read for anyone doing a venture financing. Matt – thanks a lot – look for my upcoming post on “How to give one of your star CEO’s a pay cut.”
Term Sheet Negotiations (Ode to Matt Blumberg’s Post)
Reasons to Pass on Investments
I received a number of comments, private emails, and a few links to my post on Venture Capital Deal Algebra. The consistent theme was “tell me more about how VC investments work.” As a result, I’m going to write a series of posts on the structural and financial components of a typical venture capital investment. I’m going to use a bottom up approach – talking about individual components over time and then tying them together in a comprehensive term sheet.
An important place to start is the concept of a liquidation preference. Fred Wilson hints at it in his post on valuation. A liquidation preference is a standand (and rarely negotiable part) of a VC investment. It’s the downside protection on an investment that VCs expect to have as a baseline of any equity investment.
The vast majority of VC investments are structured as preferred stock. It’s called preferred because it “sits in front of” the common stock (or is “preferred to the common”) where common stock is the plain vanilla stock that a company has. Typically in VC investments, founders receive common stock, employees receive either common stock or options to purchase common stock, and the VCs receive preferred stock. This preferred stock has a series of special rights which almost always include a liquidation preference. The liquidation preference means that the VC will have the option – in a liquidity event – of either receiving their liquidation preference as their return or converting into common stock and receiving their percentage ownership as their return.
Consider the following example. Acme Venture Capital (AVC) makes an investment in an established company called Homer Software that has been bootstrapped by the founders. Homer Software has shipped a product in an exciting market and generated $3m of revenue in the past 12 months. AVC invests $5m at a $10m pre-money valuation. As part of this investment, AVC and the founders of AVC agree to a 20% option pool for new employees that are going to be hired to be built into the pre-money valuation (see Venture Capital Deal Algebra if this doesn’t make sense). The result is that AVC owns 33.3% of the company, the founders own 46.7% of the company, and 20% is reserved for options for employees. In this example, AVC purchases Series A Preferred Stock that has a liquidation preference.
Now – consider two outcomes.
When cash or public company stock is used in an acquisition, the valuation can be mathematically determined with certainty. However, when the acquirer is a private company, the valuation is much harder to determine and is often ambiguous as it depends on the value of the private company and the type of stock (common, preferred, junior preferred, or some other special class) being used. In these cases, the use of the liquidation preference is less clear cut and it’s critical that the company have objective, outside (independent) directors and experienced outside legal counsel to help with determining valuation.
One exception to the liquidity event is an IPO. Typically, an IPO will force the conversion of preferred stock to common stock, eliminating the liquidation preference. In most cases, the IPO event is an “upside liquidity event” so the need for the liquidation preference (and corresponding downside protection) is eliminated (although this is not always the case).
Next up – To Participate or Not (Participating Preferences) – an often maligned and typically hotly negotiated issue that is a more complex form of liquidation preference.
Fred Wilson wrote a useful post on valuation today. It reminded me of a document I had Dave Jilk write when he was doing some work for me. I decided to write this “bladon” (Blog Add-on) post – inspired by Fred. Please read Fred’s post first – it lays the groundwork for why VCs do things this way.
I’ve found that even sophisticated entrepreneurs didn’t necessary grasp how valuation math (or “deal algebra”) worked. VCs talk about pre-money, post-money, and share price as though these were universally defined terms that the average American voter would understand. To insure everyone is talking about the same thing, I started passing out this document. Recognize that this is about the math behind the calculations, not the philosophy of valuation (which Fred’s blog addresses).
In a venture capital investment, the terminology and mathematics can seem confusing at first, particularly given that the investors are able to calculate the relevant numbers in their heads. The concepts are actually not complicated, and with a few simple algebraic tips you will be able to do the math in your head as well, leading to more effective negotiation.
The essence of a venture capital transaction is that the investor puts cash in the company in return for newly-issued shares in the company. The state of affairs immediately prior to the transaction is referred to as “pre-money,” and immediately after the transaction “post-money.”
The value of the whole company before the transaction, called the “pre-money valuation” (and similar to a market capitalization) is just the share price times the number of shares outstanding before the transaction:
Pre-money Valuation = Share Price * Pre-money Shares
The total amount invested is just the share price times the number of shares purchased:
Investment = Share Price * Shares Issued
Unlike when you buy publicly traded shares, however, the shares purchased in a venture capital investment are new shares, leading to a change in the number of shares outstanding:
Post-money Shares = Pre-money Shares + Shares Issued
And because the only immediate effect of the transaction on the value of the company is to increase the amount of cash it has, the valuation after the transaction is just increased by the amount of that cash:
Post-money Valuation = Pre-money Valuation + Investment
The portion of the company owned by the investors after the deal will just be the number of shares they purchased divided by the total shares outstanding:
Fraction Owned = Shares Issued /Post-money Shares
Using some simple algebra (substitute from the earlier equations), we find out that there is another way to view this:
Fraction Owned = Investment / Post-money Valuation = Investment / (Pre-money Valuation + Investment)
So when an investor proposes an investment of $2 million at $3 million “pre” (short for premoney valuation), this means that the investors will own 40% of the company after the transaction:
$2m / ($3m + $2m) = 2/5 = 40%
And if you have 1.5 million shares outstanding prior to the investment, you can calculate the price per share:
Share Price = Pre-money Valuation / Pre-money Shares = $3m / 1.5m = $2.00
As well as the number of shares issued:
Shares Issued = Investment /Share Price = $2m / $2.00 = 1m
The key trick to remember is that share price is easier to calculate with pre-money numbers, and fraction of ownership is easier to calculate with post-money numbers; you switch back and forth by adding or subtracting the amount of the investment. It is also important to note that the share price is the same before and after the deal, which can also be shown with some simple algebraic manipulations.
A few other points to note:
I’ve looked at thousands (tens of thousands?) presentations pitching new businesses since the mid 1990’s. The vast majority of them suck. Unfortunately, it’s not Powerpoint’s fault (no – it wouldn’t be better if Freelance has become the standard).
It’s the content creators fault. Edward Tufte – a master of The Visual Display of Quantitative Information, thinks Powerpoint is evil and corrupts absolutely. Blogs like Beyond Bullets help reduce the corruption, but given that I’m trying to get a very specific set of information in a short period of time (usually 30 – 60 minutes), more specificity about what I think is “good” is probably helpful.
Several years ago, Chris Wand (one of the guys that works with me at Mobius Venture Capital) put together a list of questions that a pitch to a VC should address. The world would be a better place if all entreprenuers could automagically incorporate this outline into their pitches – at least to me.
Following are the questions to address.
1) WHAT IS YOUR VISION?
– What is your big vision?
– What problem are you solving and for whom?
– Where do you want to be in the future?
2) WHAT IS YOUR MARKET OPPORTUNITY AND HOW BIG IS IT?
– How big is the market opportunity you are pursuing and how fast is it growing?
– How established (or nascent) is the market?
– Do you have a credible claim on being one of the top two or three players in the market?
3) DESCRIBE YOUR PRODUCT/SERVICE
– What is your product/service?
– How does it solve your customer’s problem?
– What is unique about your product/service?
4) WHO IS YOUR CUSTOMER?
– Who are your existing customers?
– Who is your target customer?
– What defines an “ideal” customer prospect?
– Who actually writes you the check?
– Use specific customer examples where possible.
5) WHAT IS YOUR VALUE PROPOSITION?
– What is your value proposition to the customer?
– What kind of ROI can your customer expect by using buying your product/service?
– What pain are you eliminating?
– Are you selling vitamins, aspirin or antibiotics? (I.e. a luxury, a nice-to-have, or a need-to-have)
6) HOW ARE YOU SELLING?
– What does the sales process look like and how long is the sales cycle?
– How will you reach the target customer? What does it cost to “acquire” a customer?
– What is your sales, marketing and distribution strategy?
– What is the current sales pipeline?
7) HOW DO YOU ACQUIRE CUSTOMERS?
– What is your cost to acquire a customer?
– How will this acquisition cost change over time and why?
– What is the lifetime value of a customer?
8) WHO IS YOUR MANAGEMENT TEAM?
– Who is the management team?
– What is their experience?
– What pieces are missing and what is the plan for filling them?
9) WHAT IS YOUR REVENUE MODEL?
– How do you make money?
– What is your revenue model?
– What is required to become profitable?
10) WHAT STAGE OF DEVELOPMENT ARE YOU AT?
– What is your stage of development? Technology/product? Team? Financial metrics/revenue?
– What has been the progress to date (make reality and future clear)?
– What are your future milestones?
11) WHAT ARE YOUR PLANS FOR FUND RAISING?
– What funds have already been raised?
– How much money are you raising and at what valuation?
– How will the money be spent?
– How long will it last and where will the company “be” on its milestones progress at that time?
– How much additional funding do you anticipate raising & when?
12) WHO IS YOUR COMPETITION?
– Who is your existing & likely competition?
– Who is adjacent to you (in the market) that could enter your market (and compete) or could be a co-opted partner?
– What are their strengths/weaknesses?
– Why are you different?
13) WHAT PARTNERSHIPS DO YOU HAVE?
– Who are your key distribution and technology partners (current & future)?
– How dependent are you on these partners?
14) HOW DO YOU FIT WITH THE PROSPECTIVE INVESTOR?
– How does this fit w/ the investor’s portfolio and expertise?
– What synergies, competition exist with the investor’s existing portfolio?
– What assumptions are key to the success of the business?
– What “gotchas” could change the business overnight? New technologies, new market entrants, change in standards or regulations?
– What are your company’s weak links?
Fred Wilson and I are cross posting each other today (we must miss each other) – he had a good post this morning on how turn downs work in venture capital and then followed it with a followup post about what makes a great VC.
Fred’s post on telling the truth is right on the money. One of the most infuriating experiences an entrepreneur (or VC) has to get turned down from someone with a “blow off reason” (or no reason at all). Entrepreneurs get this all the time from VCs – but VCs also get it from each other (as potential co-investors when a VC looking at a new deal turns an existing VC’s deal down) or from LPs (when they decide not to invest in a VCs new fund). While it’s unreasonable to expect people to go into excruciating detail about why they are turning you down, I’ve have much more respect for people that will give me a clear, truthful, simple reason they aren’t interested vs. an elusive, twisted, convoluted – or passive and silent – rejection. I’d much rather hear that my baby is ugly (or that I’m ugly) then get blown off.
Fred’s post made me think of two pet peeves that I have – one around rejection and the other around honesty.
Concerning rejection – even worse than a “blow off turn down” is the “slow no”. VCs are the master of this – rather than turning you down, they string you along – never saying yes, but never saying no. My advice to entrepreneurs is to drive to a definitive yes or no and – if it’s a maybe – understand why and what you have to do to move it from either a maybe to a yes or a no. Now – a maybe is ok – as long as it’s supported with both action and elapsed time (e.g. talk to me again in three months). The ambigous or unclear maybe (which is really just a string along because the VC – or whoever is stringing you along) is simply unwilling to make a decision. That’s weak.
Concerning honesty – the title of Fred’s post made me think of the millions of times I’ve heard someone start a statement with “To tell you the truth, …” or “Honestly, …”. When ever I hear this, I want to jump up and down and scream in their face “No – don’t tell me the truth – I want you to fucking lie to me!” Until a month ago I bit my tongue, but I can no longer deal with it so I do jump up and down and scream something comparable. If you are going to tell me the truth, just do it. If you are going to lie to me, do it, tell me you lied, and then delete all my contact info from your universe since I don’t ever want to deal with you ever again.
I’ll end with another one that a friend joked with me about today – “You guys are 360 degrees apart.” Now – wtf does that mean?
Last week I had a meeting with a prospective limited partner (“Mr. X”) who is long time investor in venture capital funds. He’s extremely experienced, well respected, and has a phenomenal track record. He’s also very provocative, which always spices up a meeting like this.
As we were discussing the backgrounds of the various partners at Mobius Venture Capital, I made the statement that we all have had meaningful experience as entrepreneurs and technology executives (VP level or higher) prior to becoming venture capitalists.
X immediately asked me if I had any data to support my view that this was a good thing. He said “take the top 50 individual VCs (based on historical returns) and correlate their experience – what does it show?” I thought for a minute and ran through my head some of the great VCs I know. Before I reached a conclusion, X said “it’s random – totally random – there’s no correlation to performance.”
At first, this surprised me (I was about 50/50 in my quick mental sort when he answered for me). Then – as I thought more about it – I realized that operating experience is merely an attribute that someone has rather than an indicator of performance. Experience by itself (whether operating experience or venture capital experience) is not enough – I’ve certainly worked with some abysmal VCs who have a lot of “venture capital experience” (and I’ve also worked with some abysmal VCs who have plenty of operating experience).
I pushed on what he thought actually correlated with success. He responded that the great VCs he knew had a combination of incredible instincts honed by experience combined with the ability to quickly and accurately size up situations and draw effective conclusions. He labelled this “pattern matching” – which is a good phrase for this capability.
I think the combination is what is critical – neither operating experience or pattern matching alone is enough (e.g. “I’ve seen this before, but I don’t know what to do”).
I’m sitting in a technical advisory board meeting for one of my companies (Rally Software Development). I’m moblonging from my Danger – pretty cool (at least to me).
We’re having a great meeting. I’ve sat in on a bunch of these over the last 10 years since I started investing in (vs. running) software
companies. Often, these meetings are a complete waste of time because of some disconnect between the goal of the meeting, the group of people in the room, the facilitated process – or worse – the complete dominance of one or two people.
We’ve got 15 people in the room – 5 from Rally and 10 advisors. The
chemistry is awesome – Rally is about to go GA with the first version of their product so we’re dealing with tangibles (instead of the abstract of “what should we do, where should we go”). Management is facilitating well – leting people talk, but keeping them on topic. The richness of the discussion is noticeable to everyone involved – which causes the discussion / debate to feed on itself.
This is one of the funnest parts of this job – seeing / being involved with a group of people passionate about trying to create something new and revolutionary where six months ago there was nothing.